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Relationship Between the VIX and Yield Curve

Chart showing the relationship between VIX and the yield curve steepness as it pertains to the current business cycle: 

Briefly going through the six main stages:

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1. Late-cycle

VIX becomes very low and the yield curve flattens. The yield curve can invert with respect to various short-term yields running higher than long-term yields.

Yields are partially a function of future growth and inflation outcomes. Lower long-term yields relative to short-term show less optimism about the future.

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2. Late-late-cycle

VIX elevates as does the yield curve. But the VIX moves up at a faster pace than the yield curve begins re-steepening.

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3. Early recession                    

VIX and yield curve rise in tandem as risk assets fall and the central bank cuts rates, contributing to a bullish steepening where the front end of the rates curve goes down.

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4. Mid-recession

“Fear” has reached its maximum level, VIX stays roughly level, and the central bank is in full accommodation mode, contributing to further steepening of the yield curve.

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5. Early recovery

As rates bottom and corporate earnings begin to recovery, risk assets begin increasing again, reducing VIX. The differential between short and long rates remains about equal relative to where they are mid-recession.

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6. Mid-recovery

VIX continues declining, eventually below its long-term median and average. At the same time, the yield curve begins flattening. The economy reaches a certain level of acceleration, which pushes up short-term rates faster than the increase in long-term rates. Investors are no longer compensated to the same extent for taking on duration risk.

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How can you make money with this?

Economic cycles happen for mechanical reasons related to the fact that the creation of financial assets is easier than the creation of real goods and services. If you choose to play the game, knowing where you are in the cycle is essential to growing and preserving your wealth, as it affects what assets will do well and which will do poorly and the relationships among them.

The global economy is currently late cycle. The Fed’s decision to hold off on rate hikes and its intention to stop its balance sheet run-off (though unclear when) is broadly positive and will help expand the cycle. Based on current debt servicing (relative to income and assets), the economic expansion should expand into the second half of 2020.

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Where are we now?

We’re in the stage where VIX will increase at a more rapid pace than yield spreads will increase. Therefore, expect trades that are long volatility with respect to risk assets to outperform any type of yield steepeners. 

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